Conch Republic Electronics is a midsized electronics manufacturer located in Key
ID: 2796618 • Letter: C
Question
Conch Republic Electronics is a midsized electronics manufacturer located in Key West, Florida. The company president is Shelley Couts, who inherited the company. When it was founded over 70 years ago, the company originally repaired radios and other household appliances. Over the years, the company still maintain its main service business of repairing household electronics, which accounts for about 50 percent of its total revenue. The company also expanded into the business of manufacturing electronic items. You and your team, the Carson College of Business graduates, are hired by the company's finance department to evaluate a new project for the company. One of the major revenue-producing items of Conch Republic's manufacture division is a smart phone. Conch Republic currently has one smart phone model on the market, and sales have been excellent. Conch Republic's main competitor on the smart phone market is Apple Inc. (AAPL). Conch Republic's smart phone is a unique item in that it comes in a variety of tropical colors and is preprogrammed to play Jimmy Buffett music. However, as with any electronic item, technology changes rapidly, and the current smart phone has limited features in comparison with newer models. Conch Republic spent $750,000 to develop a prototype for a new smart phone that has all the features of the existing smart phone but adds new features such as WiFi tethering. The company has spent a further $200,000 for a marketing study to determine the expected sales figures for the new smart phone. Conch Republic can manufacture the new smart phones for $215 each in variable costs. Fixed costs for the operation are estimated to run $6.1 million per year. The estimated sales volume is 155,000, 165,000, 125,000, 95,000, and 75,000 per year for the next five years, respectively. The unit price of the new smart phone will be $520. The necessary equipment can be purchased for $40.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $6.1 million. As previously stated, Conch Republic currently manufactures a smart phone. Production of the existing model is expected to be terminated in two years. If Conch Republic does not introduce the new smart phone, sales will be 95,000 units and 65,000 units for the next two years, 2 respectively. The price of the existing smart phone is $380 per unit, with variable costs of $145 each and fixed costs of $4.3 million per year. If Conch Republic does introduce the new smart phone, sales of the existing smart phone will fall by 30,000 units per year, and the price of the existing units will have to be lowered to $210 each. Net working capital for the smart phones will be 20 percent of sales and will occur with the timing of the cash flows for the year; for example, there is no initial outlay for NWC, but changes in NWC will first occur in Year 1 with the first year's sales. Conch Republic has a 35 percent corporate tax rate. The company has a target debt to equity ratio of 1 and is currently AA rated. The overall cost of capital of the company is 12 percent. The finance department of the company has asked your team to prepare a report to Shelly, the company’s president, and the report should answer the following questions.
QUESTIONS
1. Can you and your team prepare the income statement table, the operating cash flow (OCF) table, and the total cash flow from assets (CFFA) table?
2. Can you use these tables to help explain to Shelley the relevant incremental cash flows of this project?
3. Jerry, a newly graduated MBA in the company’s finance department suggested that you should use 12% as the discount rate for the discounted cash flow (DCF) analyses for this new project. Do you and your team agree with him? Can you explain why?
4. What is the cost of capital of this project? Can you explain in details to Shelley, the president, how your team comes up with the cost of capital for this project? 5. What are the NPV and IRR of the project? 6. Should Shelley take the new project? Why or why not?
Explanation / Answer
the existing COC can be used for discounting the cash flows.
1) INCOME STATEMENT: 0 1 2 3 4 5 New smart phone sales in units 155000 165000 125000 95000 75000 Sales revenue (at $520) 80600000 85800000 65000000 49400000 39000000 Variable cost (at $215) 33325000 35475000 26875000 20425000 16125000 Fixed cost 6100000 6100000 6100000 6100000 6100000 Depreciation (MACRS) 5787450 9918450 7083450 5058450 3616650 31464450 Net operating income 35387550 34306550 24941550 17816550 13158350 Tax at 35% 12385643 12007293 8729543 6235793 4605423 NOPAT 23001908 22299258 16212008 11580758 8552928 OPERATING CASH FLOW STATEMENT: NOPAT 23001907.5 22299258 16212008 11580758 8552927.5 Add: Depreciation 5787450 9918450 7083450 5058450 3616650 OCF (New smart phone) 28789358 32217708 23295458 16639208 12169578 Loss: of contribution margin on existing smart phone: Existing sales in units 95000 65000 Total contribution margin (at 380-145 = 235) 22325000 15275000 Sales in units if new phone is introduced 65000 35000 Total contribution margin (210-145=65) 4225000 2275000 Loss of contribution margin on existing phone 18100000 13000000 Incremental OCF 10689358 19217708 23295458 16639208 12169578 CASH FLOW FROM ASSETS: Incremental OCF 10689358 19217708 23295458 16639208 12169578 NWC required (for new phone) 16120000 17160000 13000000 9880000 7800000 Investment in NWC 16120000 1040000 -4160000 -3120000 -9880000 Note: NWC required is 20% of sales of new smart phone. It is to be there by the end of the year. Investment is then the difference between EOY balances of NWC. For 1st year it is 16120000-0, then 17160000-16120000 and so on. Capital expenditure 40500000 -7127443 (See note below) CFFA -40500000 -5430643 18177708 27455458 19759208 29177021 CALCULATION OF NPV: CFFA -40500000 -5430643 18177708 27455458 19759208 29177021 PVIF at 12% 1 0.89286 0.79719 0.71178 0.63552 0.56743 PV at 12% -40500000 -4848788 14491157 19542252 12557334 16555825 NPV 17797780 WORKINGS: Loss on sale of equipment at t5: Book value of the equipment = 40500000-31464450 = 9035550 Amount realized 6100000 Loss on sale 2935550 Tax shield on loss at 35% 1027443 Net cash flow after tax = 6100000+1027443 = 7127443 CALCULATION OF IRR: CFFA -40500000 -5430643 18177708 27455458 19759208 29177021 PVIF AT 23% 1 0.81301 0.66098 0.53738 0.43690 0.35520 PV AT 23% -40500000 -4415157 12015141 14754121 8632748 10363713 850568 PVIF AT 24% 1 0.80645 0.65036 0.52449 0.42297 0.34111 PV AT 24% -40500000 -4379550 11822130 14400038 8357623 9952508 -347252 IRR = 23+850568/(850568+347252) = 23.71% CONCLUSION; The project can be undertaken as the NPV is positive, because of which IRR>COC.Related Questions
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